Do Markets Need a 'Kill Switch'?

Jason Blatt of Knight Captial, Americas, LP reacts to down markets on the New York Stock Exhchange floor.

An SEC roundtable on market stability, which is taking place in Washington Tuesday, has already generated a very rare joint letter by the major stock exchanges that proposes creating a "kill switch" in an effort to control runaway algorithms, among other issues.

The exchanges are recognizing that there is a big hole in their risk management system: the presence of single-stock circuit breakers and "clearly erroneous" trading rules that allow the exchanges to bust bad trades did not prevent the kind of runaway algorithm generated by Knight Capital on August 1. (Read more: Hendelman: 'Flash' Trading & Restoring Trust)

That's not surprising, since many stocks did not have wide price swings. Here's something stranger: There is already a Market Access Rule that requires firms to have controls in place to prevent runaway algorithms. Are the rules inadequate, or was Knight not in compliance? You can bet there is a group at the SEC looking into that. Regardless: something else needs to be done.

This "kill switch," simply put, would allow the exchanges to set limits on the categories of activities that their firms are allowed to engage in, and shut them down if they exceed those limits. It would limit the total exposure each firm has to the market.

So, for example, if Knight does an average of, say, 10 million trades with a dollar value of, say, $200 million on average in the first hour of trading, and all of a sudden it does 10 times that amount, that might trigger a "kill switch" that would allow the exchange to shut down the trading session for that firm.

This joint letter was submitted by NYSE Euronext, Nasdaq , BATS, the Chicago Stock Exchange, and Direct Edge, along with a group of broker-dealers and buyside firms.

Bottom line: after what happened with Knight, the SEC and the exchanges need to plug holes in their risk management system. This is a forum for addressing those issues.

What it will not be: a forum for high-frequency trading bashing. The lineup of speakers indicates that this is mostly about how to prevent technology problems. It is a way to "check the box" after what happened with Knight. I don't expect a lot of arm flailing about the Machines Taking Over.

My take on this: the exchanges are in a tough position. Turning someone off — which is what is being proposed here — is a pretty serious step. There has to be some kind of quantitative, clear, method for determining if someone's algorithm is really out of control, or is just sending a heck of a lot of orders because they have a heck of a lot of orders. If everyone can agree on the right levels, it's a reasonable step to take.